Money & Debt Exam 2

What are the disadvantages to setting the Dgap to 0? (3)

-reduces the bank's income producing assets and thus its profitability -Banks have informational advantages for certain types of loans and will not want to eliminate loans with this advantage -Transaction costs

Because duration is best for small changes in yield, managers must rebalance their portfolios | explain the 2 reasons for when rebalancing must occur and why?

1) Following interest rate shifts so that the durations are once again match 2) over time because durations will change with time

Conversion ratio is the number of shares of common stock that bond holders receive when they exercise call option of convertible bond Name 3 important points to know about the conversion ratio:

1) conversion privilege; they extend for all or only a small portion of the bond's life 2)Conversion ratio may fall over time 3) Conversion ratio would adjust for stock splits

What do option adjusted spreads do?

Convert price differences into a yield spread measure. Professionals prefer using yield spreads. OAS is the constant spread that when added to the interest rates in the binomial tree make the theoretical value equal the market price

What are the two goals of using binomial Interest rate trees?

Create a tree of possible 1 period forward rates Use forward rates to calculate price of option free and option embedded bonds

Drawbacks to consider when Hedging Stock Prices

Delta (like duration) is only an approximation Delta changes over time

Explain why you agree or disagree with the following statement: "The value of a putable bond is never greater than the value of an otherwise comparable option free bond"

Disagree a putable bond will always be greater or equal to the value of a nonputable or noncallable bond because of the fact that a put option is added to a nonutable bond price and a put option is almost never negative.

Drawback to downside risk

Does not account for straight value changing with interest rates

Why would an investor purchase a convertible bond with a premium?

Downside protection with the potential for upside stock appreciation Premium similar to stock price call option

What are the differences between call option and convertible?

Downside risk for certain with call option

Banks typically have short term liabilities (deposits), but hold long term assets (consumer loans and mortgages) As a result, assets can be more interest rate sensitive than liabilities. If this is the case, when interest rates increase, both assets and liabilities values will fall but the value of the assets will fall more. This will negatively impact the bank's net worth This is the reason why many blanks pursue blank bank. The goal is to limit the blank between asset and liability durations

Gap management

Are potable bonds good or bad for the investor?

Good

Investors expect compensation for a low rating. Thus, rating downgrade generally results in an blank in required yield.

Increase

If duration gap is positive we interest rates blank, net worth will blank. (Vice versa)

Increase/decrease

Blank bonds help market less creditworthy issues. When Orange County defaulted a majority of the bonds were blank

Insured

Name the 3 components of total dollar return?

Interest income Capital gains Current gains or loss

What are reference rates on the floating?

Libor, commercial paper rates, federal rates

Drawbacks to buying swaps?

Liquidity, find a counter party default risk

Investment Position of a callable bond holder: Long callable bond price equals blank and blank

Long an option free bond + short call option

Investment Position of a putable bond holder: Long potable bond price equals blank and blank

Long an option free bond and long call option

Blank blank: investor contacts agent when interested in a certain maturity. Once, terms of the transactions are confirmed with the issuer, the investor may choose the maturity date (w/ approval from the company) Structured rates derivatives + medium term notes

Reverse Inquiry

Rule 415

Rule by SEC that allows companies shelf registration. Company given blanket authority to issue debt that is valid for 3 years. Provides corporation financial flexibility. In other words, those firms raising bonds /debt get to evade the process of filling out tons of legal paper work.

What is a strategy that can be utilized so that price risk and reinvestment risk cancel each other out?

Set Macaulay duration=horizon

Blank blank blank blank note. Typically less than 270 days, generally doesn't exceed 30 days. Less than 270 to avoid SEC registration. Under 90 to be eligible as collateral to borrow from the federal reserve bank's discount window (this trades lower because of demand) This is used for bridge financing--> to get from Point A to Point B

Shot term Unsecured Promissory

Treasury Auctions: blank auction Two types of bids accepted: competitive and non-competitive Non-competitive tenders: amount only -Limit: $5 Mill par value, notes, and bonds -Reasons for not submitting the non-competitive tenders, no control on prices -Tend to be small investors and institutions competitive tenders: amount and yield -Max bid at single yield: 35% of offering -Max award 35%of offering

Single

Blank blank blank Base rating on both economic and political risk There exist two sets of rating one for local currency denominated debt and one for foreign currency denominated debt. This is because currency influences risk too

Sovereign bond ratings

What is the solution to the drawbacks that arise from the use of the traditional yield spread analysis?

Static spread (0 volatility spread)

Types of marketable securities: blank blank blank In 1982: There was demand for 0 coupon notes and bonds w/ no credit risk. Two investment banks created synthetic 0 coupon bonds by buying treasury bonds and selling ownership interest in the coupon payments and principal at maturity. While not issued by the government the underlying security is a debt obligation of the government The market was not liquid because each dealer had his or her own product. Small risk that the custodian bank may go bankrupt Settlement required physical delivery, which was cumbersome and inefficient Treasury receipts (TRs)-To improve liquidity, several dealers created generic receipts; however, settlement still required physical delivery

Stripped Treasury Security

When is most likely that the static spread and traditional spreads will diverge?

The longer the maturity the bigger the difference Steeper the yield curve the greater the difference If bond pays its principal earlier (mortgage backed securities)

If the coupon rate is greater than the flat region, it is going to exhibit the behavior of a noncallable bond with positive convexity, which means that a bond will have greater price appreciation than price depreciation for a large change in yield. (T or F)

True

T or F: Different types of bonds in a corporate capital structure. Some more secure than others depending on the collateral

True

There are 5 classifications of corporate bonds:

Utilities, transportations, industrials, bank and finance companies, and Yankee and Canadian

What are the 2 drawbacks to using the traditional yield spread analysis?

YTM doesn't consider term structure of interest rates Callable and potable bonds CFs can be altered by interest rates

Why not just buy forwards, options or futures?

You can, but securities may not exist

Trading strategies using a valuation model: If market price is less than fair value, blank

buy

Commercial paper is rated like corporate bonds. Money markets are restricted by the quality of....

commercial paper they can hold

What are some red flags for investors considering GO bonds?

declining property values, increasing delinquent taxpayers, annually increasing property tax rate in conjunction w/ population decline

Multi-cashflow matching is referred to as a blank blank

dedication strategy

The following is an example of blank risk: "The prices of Triboro bonds declined sharply after Sept. 11, because investors thought that bridge and tunnel toll revenues would fall sharply after the terrorist attacks. This did not happen"

event

Municipal bonds are blank from federal income taxes

exempt However, there are taxable municipal bonds. These bonds finance projects that are not deemed to benefit the public at large

Blank blank bonds are issued by states, counties, special districts, cities, towns, and school districts generally secured by issuer's unlimited taxing power

general obligation

In the case of noncallable bonds, bonds with lower coupon rates undergo blank changes in yields when interest rates change

greater

What are the drawbacks to payback period?

ignores TVM may not apply to newer structures

Reasons to buy a swap?

immunization and cost savings

Premium payback period (break even time)

judges relative attractiveness of the convertible versus the stock shorter payback more attractive

The higher the premium over the straight value, all other factors constant, the blank attractive the convertible bond is

less

What is negative convexity?

means that the price appreciation will be less than the price depreciation for a large change in yield of a given number of basis points. For a bond that is option free and exhibits positive convexity, the price appreciation will be greater than the price depreciation for a large change in yield. It is important to understand that a bond can still trade above its call price even if it is highly likely to be called.

Modified duration is the measure of the price sensitivity of a bond's price to interest changes, assuming that the expected CFs do not change with interest rates. This method may not be appropriate for........

option embedded bonds were cost change with interest rates

Give two examples of target date immunization and explain their classification

pension funds and insurance companies Because they are interested in meeting future cost. They want to immunize the value of their portfolio for a given future target date

What is the notional principal amount?

predetermined dollar amount that interest is based off

The U.S. Treasury market consists of four diff markets: name them

primary market (where securities are first sold through an auction); secondary market (where securities are traded after they have been issued); when-issued market (where traders engage in forward transactions before securities were issued); repo market (where securities are used as collateral for loans)

Why is the investor of a callable bond exposed to reinvestment risk?

reinvestment risk is the risk caused by reinvesting fixed payments at a lower rate due to an environment of declining interest rates. The investor of a callable bond is exposed to this risk because as interest rates fall there is a greater likelihood that the callable bond will be called by the issuing firm.

Two disadvantages for investors of callable bonds

reinvestment risk: If reinvestment rates decrease, reissue at lower rate Price compression: the price appreciation for a callable bond in a declining interest rate environment is limited. This is because the market increasingly expects the bond to be redeemed at the call price as interest rates fall.

Trading strategies using a valuation model: If market price is greater than fair value, blank

sell

How do we eliminate risk in duration gap management?

set the duration equal to 0 by assuming that the duration top is positive

The blank spread does not consider how the cos will change when interest rate change in the future?

static

The minimum price of a convertible bond is the greater of the blank value or the blank value

straight or conversion

What is the solution to the issue that arises with traditional bond valuation?

Binomial tree valuation

Revenue bonds Revenue flows: project rev.-> operation and maintenance fund-> sinking fund (net operating expenses)-> Debt service **Reserve fund (covers any future shortfall)-> Renewal and replacement fund (cash for regularly scheduled and replacement)-> reserve maintenance fund (extraordinary maintenance)->surplus fund (can use cash in) can go into default Investors should question circumstances surrounding the project that could influence their ROI

Bonds are issued for a project and the revenues from the project are used to finance the bonds

Good investors do what?

Buy low, sell high

Blank blank blank Purchase securities that inflows exactly match outflows

Cash Flow matching

Blank bonds safest municipal bond issues couldn't call it to reissue for lower cost debt Gain more protection with call feature than blank feature

Refund

When calculating the price of a callable bond, why is the price of the call option subtracted?

Because it is bad for investors, investors want to pay less because it works against them because the issuer receives the proceeds from the call option

Does a callable bond exhibit negative or positive convexity?

A bond that is option-free exhibits positive convexity which means that the price appreciation will be greater than the price depreciation for a large change in yield. Positive convexity does not hold for a callable bond because when interests far bowl a certain yield level the shape of the curve begins turning inward instead of outward. Perfect parallel with a noncallable bond is not achieved even for yields a bit above the coupon rate because there is still the chance that the market yield may drop further, making investors hesitant to pay the noncallable price due to the possibility yields will fall. Negative convexity for a callable bond implies the price change is less when interest rates fall and has less of a price decrease when yield increases.

Describe Immunization

A portfolio strategy where portfolio managers match up the durations of their assets and liabilities The investment of assets in such a way that the existing business is immune to a general change in the rate of interest goal is to insulate portfolios from interest rate risk altogether

Why issue convertible debt?

Advantage is that it is over cost debt, less restrictive covenants, and M&A transactions

Blank blank blank: including interest costs, cost of registration and distribution. This is a factor that determines whether a corporation issues a MTN or corporate bond). Also, it serves as motivation for companies to issue in the h Eurobond market is that the costs are lower. The blank blank cost refer to the effective interest rate on the money raised

All in costs

How does a swap help you immunize a portfolio?

Alter the level of risk, without disrupting the underlying portfolio in your portfolio

What is an interest rate swap?

An agreement where two parties called counterparts agree to exchange the periodic interest rates

What is the drawback to traditional bond valuation?

Assumes CFs don't change with interest rates/ Not the case for bonds with options

Non-investment grade, high yield bonds, junk bonds, speculative grade bonds begin at what rating

BB+ and lower (BB+/-, BB, etc.)

Investment Grade bonds stop at what rating (the last rating considered to be investment grade)

BBB- *(AAA, AA+/-,AA, A+/-, A, BBB+/-, BBB)

How safe are General Obligation bonds?

Bc they are paid w/ taxes, they are less risky

Investors tend to hold to blank. Investors are institutional investors: money market mutual funds, pension funds, commercial bank trust, departments, state and local governments

Maturity

What is a plain vanilla interest swap?

Most common exchanged, fixed rate is swapped for floating

When duration gap is positive, we worry about interest rate increase. When duration gap is negative, we worry about interest rate decrease. When duration gap is 0, what do we worry about?

Nothing

What is the drawback to the binomial interest rate tree model?

Only as good as the assumptions use. Garbage in is garbage out

What dollars are exchanged?

Only dollars exchanged is interest payments

How do you interpret OAS spread that is based on the issuer's spot rate curve?

Over or under valuation

What happens to price and the reinvested coupons if interest rate increase?

Price will fall, coupons invested at a higher rate (opposite effects of price risk and reinvestment risk )

What is the basic rule of fixed income?

Price= PV of CFs

Debt may also be placed privately w/ one or few buyers. This is a blank blank. The issuer is not required to disclose any information to the public. Blank , among other things, allows trading of this debt between large institutions known as qualified institutional buyers (QIBs)

Private Placement/ Rule 144A

What is the role of valuation model?

Provide a fair value estimate

Why would cos change because of interest rate volatility?

Recall that corporate bonds often have embedded options like call options. The call option allows the bond issuer to pay down the bond at a specific call price prior to maturity.

How do you interpret OAS spread that is based on treasury spot rates?

Reflects credit spread + over or under valuation